Goal of an MNC and Agency Issues

The generally accepted goal of a Multinational Corporation (MNC) is to maximize shareholder

wealth. Managers of an MNC are expected to make decisions that will maximize the stock price
and thus serve the interests of the shareholders. While some publicly traded MNCs outside the
United States may have additional goals, such as satisfying their governments, creditors, or
employees, they are increasingly emphasizing satisfying shareholders to facilitate obtaining
funds. Even in developing countries, firm managers must serve shareholder interests to secure
funding.

A potential conflict arises when a corporation has shareholders who are distinct from their
managers. This conflict of goals is known as the agency problem. Managers may make
decisions that do not align with the firm's goal of maximizing shareholder wealth. For instance, a
manager might choose a subsidiary location based on personal preference rather than its
contribution to maximizing the MNC's value.

The costs associated with ensuring that managers maximize shareholder wealth, referred to as
agency costs, are typically larger for MNCs compared to purely domestic firms. This is due
to several factors:

●​ The sheer size of the MNC. Larger MNCs complicate the monitoring of managers.
●​ The scattering of distant subsidiaries. Monitoring managers of foreign subsidiaries is
more difficult due to geographical distance.
●​ The culture of foreign managers. Managers in different cultures may not have uniform
goals; some might prioritize serving their employees first.
●​ The potential conflict between maximizing subsidiary value versus overall MNC value.
Subsidiary managers might be tempted to make decisions that benefit their specific
subsidiary rather than the entire MNC.

The magnitude of agency costs can also depend on the MNC's management style. A centralized
management style allows parent managers to control foreign subsidiaries, reducing the power of
subsidiary managers and thereby reducing agency costs. However, parent managers may lack
the detailed knowledge of a subsidiary's local setting and financial characteristics that subsidiary
managers possess, potentially leading to poor decisions. A decentralized management style
gives more control to subsidiary managers who are closer to the operations and environment.
This style is more likely to result in higher agency costs if subsidiary managers do not prioritize
the value of the entire MNC. However, if subsidiary managers understand the goal of
maximizing the overall MNC's value and are compensated accordingly, decentralization can be
more effective. Some MNCs try to balance these styles by allowing subsidiary managers to make
key decisions while the parent monitors them to ensure they serve the MNC's best interest. The
internet can facilitate management control by simplifying the monitoring of foreign subsidiaries'
actions and performance.

Various forms of corporate control can reduce agency costs.

●​ Providing stock compensation for board members and executives aligns their interests
with shareholders. For example, providing managers with the MNC's stock (or options)
as part of compensation directly rewards them for decisions that enhance the MNC's
value. The example of Seattle Co. illustrates this, where the subsidiary manager's bonus
was based on the subsidiary's earnings to align incentives with the parent's goal of
maximizing shareholder wealth.
●​ The threat of a hostile takeover can incentivize managers to make decisions that
maximize firm value. If managers make poor decisions that reduce the MNC's value,
another firm might acquire it at a lower price and likely replace the management.
●​ Monitoring and intervention by large shareholders, such as institutional investors (e.g.,
mutual and pension funds), can influence management. These investors hold large
portions of an MNC's stock and can band together to demand changes, including the
removal of high-level managers or board members, in poorly performing MNCs.

The Sarbanes-Oxley Act (SOX), enacted in 2002, aimed to improve corporate governance of
MNCs by requiring more transparent reporting on firm productivity and financial condition.
SOX mandates firms to implement internal reporting processes that can be easily monitored by
executives and the board. Common methods used by MNCs to improve internal control under
SOX include establishing centralized databases, ensuring consistent data reporting across
subsidiaries, implementing systems to check data discrepancies automatically, speeding up data
access for all departments, and making executives personally accountable for the accuracy of
financial statements. These measures make it easier for board members to monitor financial
reporting, reducing the likelihood of manipulation and improving data accuracy for investors.

However, even as managers strive to maximize firm value, they may face environmental and
regulatory constraints.

Theories to Justify International Business

Several theories explain why firms are motivated to expand their business internationally. These
theories often overlap and complement each other.

1.​ Theory of Comparative Advantage: Specialization by countries in producing goods

where they have a relative advantage can increase overall production efficiency. For
example, some countries like Japan and the United States have a technology advantage,
while others like China and Malaysia have an advantage in basic labor costs. Because
these advantages are not easily transported, countries specialize and trade with others for
 products they don't efficiently produce. This classical theory explains why trade between
countries is essential and allows firms to penetrate foreign markets.
2.​ Imperfect Markets Theory: The markets for production resources are "imperfect,"
meaning factors like labor are not easily transferable between countries due to costs and
restrictions. There may also be restrictions on transferring funds and resources
internationally. MNCs often capitalize on a foreign country's particular resources because
of these imperfect market conditions.
3.​ Product Cycle Theory: As a firm matures, it may recognize additional opportunities
outside its home country. A firm typically establishes itself in its home market first due to
better access to information. Initially, foreign demand might be met through exporting.
As foreign competition increases, the firm may establish foreign subsidiaries to produce
locally, reducing transportation costs and maintaining a competitive advantage.
Differentiation of the product can help prolong foreign demand. The firm's success in
foreign markets over time depends on its ability to maintain an advantage, whether in
production, financing (reducing costs), or marketing (maintaining strong demand). The
example of 3M Co. using a new product to enter a foreign market and then expanding its
product line illustrates a strategy within this theory.

Methods to Conduct International Business

Firms use various methods to engage in international business, differing in risk and return
characteristics.

●​ International Trade: This is a relatively conservative approach involving exporting

products to foreign markets or importing supplies at a lower cost. It involves minimal
capital risk. Firms can easily reduce or discontinue this business segment at a low cost.
Large U.S. MNCs like Boeing and IBM generate significant annual sales from exporting,
but small businesses also account for a substantial portion of U.S. exports. The internet
facilitates international trade by making it easy for firms to advertise products globally
via websites, accept online orders, and track shipping. Cash flows for firms engaged in
international trade primarily result from payments for exports (inflows) or payments for
imported supplies (outflows).
●​ Licensing: An arrangement where a firm provides its technology (like copyrights or
patents) in exchange for fees or other benefits. This allows firms to generate revenue
from foreign countries without establishing production plants or transporting goods
abroad. For example, software producers licensing their software to foreign companies
for a fee. Cash flows involve outflows to cover expenses related to transferring
technology and inflows in the form of fees for the services provided.
●​ Franchising: Obligates a firm to provide a specialized sales or service strategy, support
assistance, and potentially initial investment in exchange for periodic fees. Local
residents typically own and manage the franchised units. Examples include McDonald's
 and Pizza Hut having franchises in many foreign countries. Franchising often requires a
direct investment in foreign operations and is considered a form of Direct Foreign
Investment (DFI). Cash flows involve outflows for foreign investments and inflows from
periodic fees.
●​ Joint Ventures: Firms penetrate foreign markets by engaging in a joint venture (joint
ownership and operation) with firms residing in those markets. Joint ventures allow firms
to combine their respective comparative advantages. They often require some degree of
DFI, with the other parties also participating in the investment. Examples include General
Mills' venture with Nestlé for cereal distribution in Japan and Xerox's venture with Fuji
Co. for the photocopying business in Japan. Joint ventures between automobile
manufacturers are common due to the ability to share technological advantages. Cash
flows involve outflows for funding partial investment and inflows from fees for services
provided.
●​ Acquisitions of Existing Operations: Firms acquire existing companies in foreign
countries. This method provides quick control over foreign operations and market share.
Acquisitions represent DFI because they involve directly investing in a foreign country
by purchasing target company operations. Google, Inc. has made numerous international
acquisitions to expand its business and technology. However, acquisitions require large
investments and carry the risk of significant losses if foreign operations perform poorly.
Partial international acquisitions require smaller investments and less risk but do not
grant complete control. This method, involving DFI, results in cash flows from the parent
financing subsidiary operations and cash flows from subsidiaries remitting earnings and
fees to the parent.
●​ Establishment of New Foreign Subsidiaries: Firms can penetrate foreign markets by
establishing new operations in foreign countries to produce and sell their products. This
method also requires substantial DFI. Establishing new subsidiaries can be preferable to
acquisitions as operations can be tailored to the firm's specific needs, and the initial
investment might be smaller than acquiring existing operations. However, it takes time to
build the subsidiary and establish a customer base before realizing returns. This method,
involving DFI, results in cash flows from the parent financing subsidiary operations and
cash flows from subsidiaries remitting earnings and fees to the parent.

In general, any method involving a direct investment in foreign operations is referred to as

Direct Foreign Investment (DFI). International trade and licensing are typically not considered
DFI, while franchising and joint ventures involve limited DFI, and foreign acquisitions and
establishing new subsidiaries involve substantial DFI. Many MNCs use a combination of these
methods. The example of Nike's evolution illustrates using licensing, exporting, and direct
foreign investment (through establishing licensed factories and expanding operations) to grow
international sales.

Current International Financial Landscape

The sources provide insights into the current international financial landscape, highlighting both
opportunities and increased risk exposure for MNCs. International business increases an MNC's
exposure to:

●​ Exchange rate movements: Fluctuations in exchange rates affect cash flows and foreign
demand.
●​ Foreign economies: Economic conditions in foreign countries affect demand for the
MNC's products.
●​ Political risk: Political actions in foreign countries can affect cash flows.

Opportunities in Europe include the EU Recovery Plan (NextGenerationEU fund), the European
Green Deal & Sustainable Finance initiatives, and the Digital Euro Initiative. Challenges include
the Brexit aftermath and Inflation and Interest Rate Hikes.

Opportunities in Latin America include the United States-Mexico-Canada Agreement (USMCA),

Latin America's role in Global Energy Transition (e.g., Lithium Triangle, Brazil), and the growth
of Digital Payments and Fintech (e.g., Neobanks, PIX). Challenges include ongoing Debt Crises
and IMF Bailouts in countries like Venezuela and Argentina.

Opportunities in Asia include India's Rapid Economic Growth and Digital Finance Boom (India
became the 5th largest economy in 2022, with initiatives like UPI and a piloting digital rupee),
Japan's Yen Depreciation supporting an export-driven recovery strategy, and the Rising Financial
Integration of ASEAN countries (experiencing massive FDI in tech and manufacturing). China
presents a complex landscape with its Economic Slowdown and Real Estate Crisis, but also a
shift in the Belt and Road Initiative towards high tech investment. China has banned
cryptocurrency trading, while Hong Kong and Singapore are emerging as crypto-friendly or
leading regulators in digital assets.

Valuation Model for an MNC

The value of an MNC is relevant to its shareholders and debt holders. Financial decisions that
maximize the present value of future cash flows maximize the firm's value and shareholder
wealth.

For a purely domestic firm in the United States, the value (V) is the present value of its expected
dollar cash flows: V = Σ E(CF$,t) / (1 + k)^t where E(CF$,t) is the expected dollar cash flow at
the end of period t, n is the number of future periods, and k is the required rate of return by
investors, representing the weighted average cost of capital. Expected cash flows are influenced
by investment decisions, and the required rate of return (k) is influenced by financing decisions
and the firm's risk.
An MNC's value can be specified similarly, but its expected cash flows may come from various
countries and be denominated in different foreign currencies. These foreign currency cash flows
must be converted into dollars to determine the total expected dollar cash flows. The expected
dollar cash flows to be received at the end of period t are the sum of the products of cash flows in
each currency (CFj,t) multiplied by the expected exchange rate (ERj,t) at which that currency can
be converted to dollars: E(CF$,t) = Σ [E(CFj,t) * E(ERj,t)] for j = 1 to m currencies

The general formula for valuing an MNC receiving multiple currencies over multiple periods is:
V = Σ [Σ (E(CFj,t) * E(Sj,t))] / (1 + k)^t where CFj,t is the cash flow in currency j at time t, Sj,t
is the exchange rate converting currency j to dollars at time t, and the summation is over all
currencies (j=1 to m) and all future periods (t=1 to n). Cash flows of subsidiaries are included
only when they are expected to be remitted to the parent to avoid double counting. The weighted
average cost of capital (k) for an MNC is based on funding projects in different countries, and
decisions affecting the cost of capital for projects in a specific country will impact the overall k
and thus the MNC's value.

The example of Carolina Co. illustrates calculating expected dollar cash flows from domestic
operations (already in dollars) and foreign operations (in Mexican pesos converted to dollars).
The example of Austin Co. further demonstrates calculating total dollar cash flows from U.S.
operations and European operations (in euros converted to dollars).

An MNC's future cash flows and valuation are subject to uncertainty due to exposure to
international economic conditions, political conditions, and exchange rate risk.

●​ Exposure to International Economic Conditions: Foreign economic conditions affect

the demand for an MNC's products and thus its cash flows. Improved economic
conditions in a foreign country can increase consumer income and employment, leading
to higher demand and cash flows for the MNC. Conversely, weaker conditions reduce
demand and cash flows. The example of Facebook acknowledges its exposure to
international economic conditions as it expands overseas. International economic
conditions can also indirectly affect the MNC's home economy and domestic cash flows.
For instance, weak European economic conditions can reduce European demand for U.S.
exports, potentially weakening the U.S. economy and reducing U.S. demand for products
offered by U.S.-based MNCs. The example of Austin Co. shows how a European
recession can reduce expected cash flows from both European and U.S. operations.
●​ Exposure to Political Risk: Political actions in a foreign country, such as increased
taxes, barriers, consumer boycotts due to friction between governments, or unstable
political conditions (country risk), can reduce an MNC's cash flows. The example of
Russia banning U.S. food imports in retaliation for sanctions illustrates how political
actions can adversely affect the sales and cash flows of MNCs even if they are not
directly involved in the political dispute.
 ●​ Exposure to Exchange Rate Risk: If foreign currencies in which an MNC receives cash
flows weaken against the dollar, the dollar amount received will be lower than expected,
reducing cash flows. The example of Austin Co. shows how a weaker euro can reduce the
expected dollar cash flows from European operations. Conversely, if the currencies
received appreciate, dollar cash flows increase. Google, receiving significant revenue
from outside the U.S. in foreign currencies, is favorably affected when those currencies
appreciate against the dollar. Facebook's increasing international business makes its
dollar cash flows more sensitive to exchange rate movements. MNCs also have cash
outflows in foreign currencies (e.g., for importing supplies). If these foreign currencies
strengthen, the MNC requires more dollars to make payments, reducing its net dollar cash
flows and value.

Uncertainty surrounding an MNC's future cash flows, stemming from these international
exposures, increases the required rate of return by investors (the cost of capital, k), which lowers
the firm's valuation. If uncertainty declines, the cost of capital decreases, and valuations
increase.

The valuation model shows that an MNC's value (V) is favorably affected when expected foreign
cash inflows increase, the value of currencies denominating those inflows increases, or the
required rate of return decreases. Conversely, value is adversely affected when expected foreign
cash inflows decrease, the value of currencies denominating net foreign cash inflows decreases,
or the required rate of return increases.

Financial decisions by MNCs are broadly classified as investing decisions (affecting expected
cash flows, the numerator, and potentially the cost of capital, the denominator) and financing
decisions (primarily affecting the cost of capital, the denominator).

The sources also present hypothetical scenarios like Blades, Inc. considering international
expansion through importing from and exporting to Thailand due to a decline in domestic sales
and cost advantages abroad. This case touches upon comparative advantage (low costs in
Thailand), imperfect markets (difficulty transferring workers), and the product cycle theory
(expanding after domestic success). Another scenario, Sports Exports Company, illustrates a
small business starting with exporting U.S.-style footballs to foreign markets due to limited
domestic opportunities, highlighting the potential for international growth based on identifying
demand in new markets. This example also mentions lower agency costs for a smaller firm and
considering less costly methods than DFI.